Chapter 8: Monopoly, Oligopoly, and Monopolistic Competition

Learning Objectives Define imperfect competition and compare it to perfect competition Define market power and explain how it affects the firm's demand curve Explain how start-up costs affect economies of scale and market power Understand and use marginal cost and marginal revenue to maximize monopolist's profit Show how monopoly alters economic surplus compared to perfect competition Describe price discrimination and its effects Discuss public policies applied to natural monopolies

Imperfect Competition Millions of people around the world suffer from allergies The symptoms can be treated using over-the-counter or prescription medication Over-the-counter medication is affordable Prescription medication is expensive Prescription medication costs no more to manufacture than over-the-counter medication  their producer earns an enormous profit In a perfectly competitive market if an economic profit exists  firms enter the market and prescription medication would sell for roughly its cost of production

Imperfect Competition But prescription medication has been on the market for years now and that hasn’t happened The reason is that prescription medication is patented, which means the government has granted the creator of the medication an exclusive license to sell it The holder of a patent is an example of an imperfectly competitive firm, or price setter A firm with some liberty to set its own price

Imperfect Competition Imperfectly competitive firms have some control of price Long-run economic profits possible / Reduce economic surplus Three types Monopoly has only one seller, no close substitutes Farthest from perfectly competitive markets Monopolistic competition has many firms with differentiated products These products are all close substitutes No significant barriers preventing firms from entering or leaving the market

Imperfect Competition Three types Oligopoly is a small number of firms producing close substitutes Oligopoly is typically a consequence of cost advantages that prevent small firms from being able to compete effectively

P, Q, product differentiation Monopoly Monopoly Number of Firms One firm Price Price setter Entry and Exit Not free Product Unique Economic Profits Possible Decisions P, Q, product differentiation Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only

Monopolistic Competition Number of Firms Many firms Price Limited flexibility Entry and Exit Free Product Differentiated Economic Profits Zero in long run Decisions P, Q, product differentiation Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only

Oligopoly Oligopoly Number of Firms Few firms, each large Price Some flexibility Entry and Exit Large size firm Product Differentiated or standardized Economic Profits Possible Decisions P, Q, differentiation, advertising Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only

The Essential Difference Whereas the perfectly competitive firm faces a perfectly elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve Why is the demand curve different? Market Power Quantity Price Imperfectly Competitive Firm Quantity Price Perfectly Competitive Firm D D

The Essential Difference Market power is the firm's ability to raise its price without losing all its sales Perfectly competitive firm: Raise the price  loses all its sales No incentive to lower price since it can sell as many units as it wants at the market price Imperfectly competitive firm: Has incentive to charge a higher price  lose some customers but keep some and maybe gain more

Five Sources of Market Power A firm with a down-ward sloping demand curve is said to enjoy market power Referring to its ability to set the prices of its products Five Sources of Market Power Exclusive control over inputs Patents and copyrights Government licenses or franchises Economies of scale (natural monopolies) Network economies

Exclusive Control over Inputs If a single firm controls an input essential to the production of a given product, that firm will have market power For example, to the extent that some tenants are willing to pay a premium for office space in the world’s tallest building, Burj Khalifa, the owner of that building has market power

Patents and Copyrights Patents give the inventors or developers of new products the exclusive right to sell those products for a specified period of time By insulating sellers from competition for an interval, patents enable innovators to charge higher prices to recoup their product’s development costs Pharmaceutical companies in the US are given 20 years patents During that time, these companies can charge a price above their marginal cost

Government Licenses or Franchises Example: The Tourism Development & Investment Company (TDIC) has an exclusive license from the Abu Dhabi government to manage all operational aspects of eight islands off the western coast of Abu Dhabi One of the government’s goals in granting this monopoly was to preserve the wilderness character of the area to the greatest degree possible

Market Power: Economies of Scale Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs Long–run idea Constant returns to scale: doubling all inputs doubles output Increasing returns to scale: output increases by a greater percentage than the increase in inputs Average costs decrease as output increases Natural monopoly: a monopoly that results from economies of scale

Market Power: Network Economies Network economies occur when the value of the product increases as the number of users increases VHS format for video tapes, Blu-ray for DVDs Windows operating system Facebook and MySpace Network economies can also be seen as a source of natural monopolies A product’s quality increases as the number of users increases Any given quality level can be produced at lower cost as sales volume increases

Market Power The most important and enduring of these sources of market power are economies of scale and network economies Other sources are weak Lured by economic profit, firms almost always find substitutes for exclusive inputs Firms can often evade patent laws by making slight changes in design of products Patent protection is only temporary in any case Governments grant very few franchises each year

Economies of Scale and Start-Up Costs New products can have a large fixed development cost If marginal cost is constant, Marginal cost = Average variable cost Total cost is fixed cost (F) plus variable cost TC = F + (M)*(Q) Total cost increases as output increases Average total cost is ATC = (F/Q) + M Average total cost decreases as output increases

Economies of Scale TC = F + M*Q ATC = F/Q + M Average cost ($/unit) Quantity F TC = F + M*Q ATC = F/Q + M Total cost ($/year) M Quantity

Video Game – Different Volumes Nintendo Playstation Annual Production (000s) 1,000 1,200 Fixed Cost ($000s) $200 Variable Cost ($000s) $800 $960 Total Cost ($000s) $1,000 $1,160 ATC per game $1.00 $0.97

Video Game – Lower Marginal Costs Nintendo Playstation Annual Production (000s) 1,000 1,200 Fixed Cost ($000s) $200 Variable Cost ($000s) $240 Total Cost ($000s) $400 $440 ATC per game $0.40 $0.37

Video Games – Higher Fixed Cost Nintendo Playstation Annual Production (000s) 1,000 1,200 Fixed Cost ($000s) $10,000 Variable Cost ($000s) $200 $240 Total Cost ($000s) $10,200 $10,240 ATC per game $10.20 $8.53

Video Games – Different Production Levels Nintendo Playstation Annual Production (000s) 500 1,700 Fixed Cost ($000s) $10,000 Variable Cost ($000s) $100 $340 Total Cost ($000s) $10,100 $10,240 ATC per game $20.20 $6.08

Intel's Advantage In 1984, 80 percent of the cost of a computer was in its hardware (which has relatively high marginal cost) The remaining 20 percent was in its software By 1990 those proportions were reversed Fixed cost now accounts for about 85 percent of total costs in the computer software industry Development cost of a new chip $2 billion Marginal cost of making a chip Pennies Dominating the market Priceless! Intel supplies more than 80% of the processors for PCs!!!

Profit Maximization for a Price Setter Regardless of whether a firm is a price taker or a price setter its basic goal is to maximize its profit In both cases: The firm expands output as long as the benefit of doing so exceeds the cost Further, the calculation of marginal cost is also the same for the monopolist as for the perfectly competitive firm Difference is in the calculation of the marginal revenue

Monopolist Pure monopoly: the only seller of a unique product which has no close substitutes Like all other firms, a monopolist Maximizes profits Applies the Cost-Benefit Principle Increase output if marginal benefit > marginal cost Decrease output is marginal benefit < marginal cost Marginal benefit (marginal revenue) for a monopolist is different than for a perfectly competitor

Profit Maximization for the Monopolist For the monopolist, selling one more unit Decreases market price Reduces marginal revenue by more than the price Lower price applied to all units Price ($/unit) Quantity (units/week) D 2 6 3 5

Monopolist's Marginal Revenue Price & marginal revenue ($/unit) 8 D Quantity (units/week) MR 3 2 1 4 -1 5 Price Quantity $6 2 $5 3 $4 4 $3 5 Total Revenue $12 $15 $16 Marginal Revenue 3 1 -1

Monopoly Demand and Marginal Revenue In general, the monopolist's marginal revenue curve Has the same intercept as demand Has twice the slope of demand Lies below demand Price Quantity a D Q0 Q0/2 a/2 MR

Deciding Quantity A monopolist knows his demand and marginal revenue curves Marginal cost is also known If he operates at P = $3 and Q = 12, MC > MR Decrease output If the firm operates at Q = 8, then MC = MR = 2 The demand curve sets the price, P = $8 At any output below 8, MC < MR 6 D 12 MR MC 4 8 Price ($/unit of output) 3 2 Quantity (units/week)

Does being a Monopolist Guarantee Profits? Being a monopolist does not guarantee positive profits The question comes down to: At MR = MC, is the P larger or smaller than ATC? If P > ATC  positive profits If P < ATC  negative profits (losses)

Monopoly Losses and Profits Price ($/minute) Minutes (millions/day) 24 20 0.08 0.10 ATC D 0.05 MC MR Economic loss = $400,000/day Economic profit = $400,000/day 0.12 ATC 0.10 Price ($/minute) 0.05 MC D MR 20 24 Minutes (millions/day)

The Invisible Hand Fails The monopolist's optimal amount occurs where MC = MR, Q = 8 units and P = $4 24 D 3 12 6 Marginal Cost 2 MR 8 4 The socially optimal amount occurs where MC = MB, Q = 12 units and P = $3 Deadweight loss from monopoly = $4 Price ($/unit of output) Quantity (units/week)

The Invisible Hand Fails Since the monopolist’s marginal revenue is always less than price, the monopolist’s profit-maximizing output level is always below the socially efficient level Under perfect competition, by contrast, profit maximization occurs when marginal cost equals the market price (MB = Demand) - the same criterion that must be satisfied for social efficiency This difference explains why the invisible hand of the market is less evident in monopoly markets than in perfectly competitive markets

The Invisible Hand Fails The source of inefficiency in monopoly markets is the fact that the benefit to the monopolist of expanding output is less than the corresponding benefit to society MR < MB = Demand From the monopolist’s point of view, the price reduction the firm must grant existing buyers to expand output is a loss From the point of view of those buyers, each dollar of price reduction is a gain—one dollar more in their pockets

Monopoly and Perfect Competition MC = MR P >MR P > MC Deadweight Loss Perfect Competition P = MR P = MC No Deadweight Loss

Monopolies exist for economic reasons Managing Monopoly Monopolies exist for economic reasons Patents, copyrights and innovation Economies of scale Network economies Anti-trust laws attempt to limit deadweight loss Limiting monopolies has costs Patents encourage innovation Economies of scale minimize ATC Network economies increase benefits

Price Discrimination Price discrimination means charging different buyers different prices for essentially the same good or service Separate the groups No side trades among buyers Many forms of price discrimination Perfect discrimination: negotiate separate deals with each customer Hurdle method: discounts for identifiable groups (e. g., students, senior citizens)

Price Discrimination Whenever a firm offers a discount, the goal is to target that discount to buyers who would not purchase the product without it People with low incomes generally have lower reservation prices for museum tickets than people with high incomes Because students generally have lower disposable incomes than working adults, museum owners can expand their visitors by charging lower prices to students than to adults

Carla the Editor: Example Carla is a teaching assistant supplementing her income by editing term papers for undergraduates There are eight students per week (A,B,C,D,E,F,G and H) for whom she might edit, each with a different reservation price If the opportunity cost of her time to edit each paper is $29 (also equal to her MC) and she must charge the same price to each student (no price discrimination) How many papers should she edit? How much economic profit will she make? How much accounting profit?

Opportunity cost of Carla's time is $29 Carla the Editor Opportunity cost of Carla's time is $29 Student Reservation Price A $40 B 38 C 36 D 34 E 32 F 30 G 28 H 26 Total Revenue $40 $76 $108 $136 $160 $180 $196 $208

Opportunity cost of Carla's time is $29 Carla the Editor Opportunity cost of Carla's time is $29 Student Reservation Price A $40 B 38 C 36 D 34 E 32 F 30 G 28 H 26 Total Revenue $40 $76 $108 $136 $160 $180 $196 $208 MR $40 $36 $32 $28 $24 $20 $16 $12

Carla the Editor: Ordinary Monopolist Carla is a profit maximizer Carla should keep expanding the number of students she serves as long as her MR exceeds the opportunity cost of her time (MC) Carla should stop at 3 papers since MR = 32 > MC = 29 Total opportunity cost = 3 * 29 = $87 Economic profit = 108 – 87 = $21 Accounting profit = $108 (since no explicit costs) = TR

Carla the Editor: Social Optimum What is the socially efficient number of papers for Carla to edit? Students A to F are willing to pay more than her opportunity cost ($29) Students G and H are unwilling to pay at least $29 Socially efficient outcome is to edit 6 papers To be able to achieve that she has to charge a price no higher to $30 (the lowest willing price, here of student F) TR = 6 * 30 = $180 and Opportunity Cost = 6 * 29 = $174  Economic profit = $6 Accounting profit = TR = $180

Carla the Editor: Price Discrimination Opportunity cost of Carla's time is $29 Student Reservation Price A $40 B 38 C 36 D 34 E 32 F 30 G 28 H 26 Total Revenue $40 $78 $114 $148 $180 $210 $238 $264

Carla the Editor: Price Discrimination What if Carla knew exactly the reservation price of each student? How many papers should she edit, and how much economic and accounting profit will she make? She will edit papers for students A to F again But this time charge each their reservation price Carla is a perfectly discriminating monopolist TR = 40 + 38 + 36 + 34 + 32 + 30 = $210 Opportunity cost = 6 * 29 = $174 Economic profit = $36

Carla the Editor: Price Discrimination Notice that the profit-maximizing level of output under perfect price discrimination was exactly the same as the socially efficient level of output With a perfectly discriminating monopoly, there is no loss of efficiency Note that although total economic surplus is maximized by a perfectly discriminating monopolist, consumers would have little reason to celebrate Consumer surplus is exactly zero for the perfectly discriminating monopolist Total economic surplus and producer surplus are one and the same

Carla the Editor: Price Discrimination In practice, of course, perfect price discrimination can never occur because no seller knows each and every buyer’s precise reservation price Also in many markets the seller could not prevent buyers who bought at low prices from reselling to other buyers at higher prices, capturing some of the seller’s business in the process In general imperfect price discrimination is more prevalent Imperfect price discrimination: at least some buyers are charged less than their reservation prices

Carla the Editor: Price Discrimination The profit-maximizing seller’s goal is to charge each buyer the highest price that buyer is willing to pay Two primary obstacles prevent sellers from achieving this goal First, sellers don’t know exactly how much each buyer is willing to pay Second, they need some means of excluding those who are willing to pay a high price from buying at a low price One way is to follow the hurdle method of price discrimination

Hurdle Method of Price Discrimination The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle Hard cover and paperback books Commercial air carriers Temporary sales A perfect hurdle is one that separates buyers precisely according to their reservation prices

Carla the Editor: Price Discrimination Carla offers a rebate coupon that gives a discount to any student who takes the trouble to mail it back to her Suppose further that students whose reservation prices are at least $36 never mail in the rebate coupons Those whose reservation prices are below $36 always do so What should her list price be, and what amount should she offer as a rebate? Will her economic profit be larger or smaller than when she lacked the discount option?

If reservation price < $36, mail in rebate Carla Offers a Rebate If reservation price < $36, mail in rebate Student Reservation Price Total Revenue A $40 B 38 76 C 36 108 MR $40 36 32 Discounted Price Submarket D $34 E 32 64 F 30 90 G 28 112 H 26 130 $34 30 26 22 18

Carla the Editor: Price Discrimination Carla will divide the market into two groups and act as an ordinary monopolist  compare MR and MC 1st group = list price submarket: A,B and C Charge $36 and serve all three students 2nd group = discount price submarket: D,E,F,G and H Charge $32 and serve D and E only (discount = $4) Combined TR from both submarkets = 3 * 36 + 2 * 32 = $172 Opportunity cost = 5 * 29 = $145 Economic profit = 172 – 145 = $27

Perfect Discriminator Carla's Choices Program Social Optimum Papers Edited 6 Price $30 Total Revenue $180 Carla's Time   $174 Economic Profit $6 Total Surplus $26 Single Price 3 $36 $108 $87 $21 $27 Perfect Discriminator 6 Reservation $210 $174  $36 Hurdle 5 = (3 + 2) $36, $4 rebate $172 $145  $27 $35

Is Price Discrimination a Bad Thing? Although we might think so, but it is not necessary Total surplus was actually enhanced by the monopolist’s use of the hurdle method of price discrimination TS = CS+PS CS = reservation price minus price actually paid PS = charged price minus reservation price ($29) Ordinary monopoly: TS = $27 CS = 4 + 2 + 0 = $6 ; PS = 3(36 – 29) = $21 Hurdle price discriminate: TS = $35 CS = 4 + 2 + 0 + 2 + 0 = $8; PS = 3(36 – 29) + 2(32 – 29) = $27

Monopoly and Public Policy Monopoly is problematic: Loss in efficiency associated with restricted output Monopolist earns an economic profit at the buyer’s expense Goal of people is to control monopolies Policy options Government ownership and operation Regulation Competitive bids for natural monopoly services Break up

State-Owned Natural Monopoly Marginal cost is always less than average cost Marginal cost pricing produces losses Options Fund losses from tax revenues Fixed monthly fee plus usage fee Fixed fee covers losses Limited incentives to innovate and cut costs Commonly used for water, Post Office and electricity

Used for electricity, telephone and cable Disadvantages Regulated Monopolies Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs Used for electricity, telephone and cable Policies vary by state Disadvantages High administrative cost Reduced incentive for cost-saving innovation Price is greater than marginal cost

Government awards contract to low bidder for natural monopoly services Bid for Contract Government awards contract to low bidder for natural monopoly services Garbage collection, fire protection, road construction, Department of Defense Could achieve marginal cost pricing IF government pays the resulting losses Asset transfer for large fixed investment is complex

Applies to mergers and acquisitions today Anti-Trust Laws Two landmark laws Sherman Act of 1890 Declared conspiracy to create a monopoly illegal Clayton Act of 1914 Outlawed transactions that would "substantially lessen competition" Applies to mergers and acquisitions today IBM avoided break-up; AT&T did not Microsoft survived

Another Policy Option: Ignore Monopoly Two objections to monopolies Restrict output, decrease total surplus Raise price, earn economic profits Analysis Discount offers allow some customers to pay less than average cost, though more than marginal cost Economic profits generated by customers who pay list price – their choice About two-thirds of economic profits are taxed away Remainder accrues to shareholders

The Algebra of Monopoly Maximization Chapter 9 Appendix The Algebra of Monopoly Maximization

From Demand to Marginal Revenue Given a demand curve such as P = 15 – 2 Q We can write the marginal revenue curve as MR = 15 – 4 Q Suppose marginal cost is a line with zero intercept and a slope of 1 MC = Q The remaining step is to set marginal revenue equal to marginal cost

Let Q* be the profit maximizing level of output MR = MC Let Q* be the profit maximizing level of output MC = MR Q* = 15 – 4 Q* 5 Q* = 15 Q* = 3 To find P, substitute Q = 3 into the demand equation P = 15 – 4 Q* P = 15 – 4 (3) P = 3